Pricing District Heating

Price is the most important element affecting a firm’s market share and profitability. Kotler and Armstrong (2014, p. 312) define price as “the sum of all the values that consumers give up to gain the benefits of having or using a product or service”. Price is an element in the marketing mix, along with product, place and promotion. The marketing mix is a set of tactical marketing tools that a firm combines to produce the responses it wants form its target market. Of these elements, price is the most important, as it is the only element that produces revenue; all other elements produce costs. Pricing is therefore a strategic tool for creating and capturing consumer value (Kotler & Armstrong, 2014).

Perhaps the most decisive factor for a firm’s pricing behavior is the degree of market competition. Thus, the market situation of a firm will guide their pricing method. Firms encountering little or no market competition will place more emphasis on long-term pricing strategies than firms with a large degree of competition. Long-term pricing policies smooth out fluctuations in costs and demand, making room for more predictable future projections (Àlvarez & Hernando, 2006). The following sub-sections will examine pricing in the case of a natural monopoly, and the different pricing mechanisms currently used for district heating. In the literature on district heating pricing, two representative methods are most common:

marginal cost pricing and cost-plus pricing.

4.3.1 Pricing under Natural Monopoly Power

Figure 4.1 illustrates the relationship between demand, marginal revenue and the cost curves for a natural monopoly. The ATC curve represents the average total cost, MC is the marginal cost curve, D is the demand curve and MR is the marginal revenue curve. A rule of thumb for identifying a natural monopoly is that the demand curve intersects ATC while ATC is still

downward sloping. What distinguishes a natural monopoly from a pure monopoly is that the ATC diminishes over a much larger range of output than for a regular monopoly. The ATC reaches its minimum point at some level of output far beyond the point of intersection between the demand curve and ATC. Thus, a natural monopoly experiences economies of scale on a much larger range of output that a regular monopoly would. Therefore, the natural monopoly must produce a much greater output that a regular monopoly in order to minimize its average total costs. Also, because average costs are declining, marginal cost is always below average cost (Welker, 2012).

Figure 4.1 - Natural Monopoly

Source: Adapted from Mosca (2008)

From figure 4.1, it is shown that the intersection of the demand curve and the marginal cost curve (MC=D=MB) gives an output of Q(so) and a price P(so), displaying the socially optimal quantity and price. In the absence of regulation, the natural monopoly would produce at output level Q(m) and receive a price of P(m), according to the profit maximization rule MR=MC. In such a case, the price P(m) will be larger that the socially optimal price of P(so), and the firm will produce less than what is socially optimal. This poses a dilemma: a natural monopoly exists in this market, but if this one monopoly firm is allowed to charge the price it wishes to charge in order to maximize its profits, it will restrict its outputs to Q(m) and charge a price that is much higher than what is socially desirable. This means that there will be an under-allocation of resources. They are now extracting surplus from consumers and

transferring it as profit to the natural monopolist. To solve this problem, government intervention is required (Welker, 2012).

A combination of price controls and subsidies can contribute to achieve a more socially optimal level of output. These regulatory tools aim to incentivize natural monopoly firms to produce at the socially optimal level. However, at the social optimum, the price would not cover average total costs, and the firm will run at a loss. This happens because the firm must meet various levels of demand (peak and off-peak demand), and the firm therefore has substantial excess production capacity in periods where demand is stable (McConnell et al., 2012). There are several options a firm can utilize to solve this problem. One option is to be publically subsidized to cover the loss that marginal cost pricing would result in. Another is to use price discrimination to charge different prices to different consumers.

Recognizing that the socially optimal price leads to losses, regulatory agents impose the price P(r) to provide a fair rate of return to the monopolist. The best alternative is therefore to set the price at the minimum feasible price P(r), where average cost and demand intersect (McConnell et al., 2012).

4.3.2 Cost-Plus Pricing

The cost-plus pricing method is most commonly used for regulated district heating markets.

With the method, the firm estimates or calculates average variable costs (AVC) and sets the price by marking up the AVC by a percentage. This mark-up takes the firm’s fixed costs and a profit margin into consideration (Lipczynski et al., 2009). The price is then calculated as:

P = AVC + % mark-up (4.16)

or P = (1+m)AVC (4.17)

Where P is price, and the mark-up is 100×m percent. More specifically, for a regulated district heating market, the price for district heating equals the sum of costs to be recovered (the average variable costs) and a reasonable profit for district heating companies (the mark-up) (Li et al., 2015). The key issue in pricing district heating by cost-plus pricing is to determine the permitted profits a district heating company can make. This can be shown as:

PriceDH = OA + AD + PP (4.18)

In equation 4.18, OA is operating costs, AD is annual depreciation, and PP is permitted profit.

Permitted profits can among other ways be calculated rate of return on capital (ERO, 2009):

PP = WACC × RAB (4.19)

Where WACC is the weighted average cost of capital, and RAB is depreciated fixed cost, new investment and labor cost. Even though the aim of regulatory action is to prevent firms from abusing market power, issues related to the firm’s incentives could arise. Since the permitted profits are related to the firm’s costs, there is an incentive to inflate costs to gain larger profits. This can weaken district heating suppliers’ motivation to introduce cost reducing initiatives such as technology updates. Consequently, the price will stay large or increase, undermining the purpose of regulatory intervention (Zhang et al., 2013).

4.3.3 Marginal Cost Pricing

For deregulated district heating markets, the most common pricing mechanism is the marginal cost method. In the case of district heating, the marginal cost refers to the additional cost of generating another unit of heat, usually measured in kWh. Due to cost considerations, a district heating firm using several production facilities will tend to run low-cost facilities before running high-cost facilities. The marginal cost is obtained from the facility with the highest operating costs (Li et al., 2015). Normally, marginal costs are divided into fixed and variable costs. Marginal cost is then the additional unit of variable costs plus the depreciations of fixed costs (Difs & Trygg, 2009). The marginal cost is calculated as follows:

Marginal Cost = ^dVC_dQ

+

Where VC are variable costs, FC are fixed costs and Q is production quantity. Since fixed costs are constant, regardless of production quantity, ^{𝑑𝑑𝑑𝑑𝑑𝑑}

𝑑𝑑𝑑𝑑 will be zero in the short run. The variable heat cost can be expressed by the energy balance:

Heat = Fuel × η (4.21)

Where 𝜂𝜂 is the efficiency of the facility. When taxes are charged on fuels, carbon emissions and other pollutants, the cost can be written as:

Heat × VC(Heat-boiler) = Fuel × (Costfuel + Taxcarbon + Taxenergy + TaxSulphur) (4.22)

From equation 4.22,

VC(heat-boiler) = ^{Costfuel+ Taxcarbon+ Taxenergy+ TaxSulphur}

η

In equations 4.22 and 4.23, the component Costfuel is the element subject to most variation, because the prices of fuels are subject to rapid change. The marginal cost of the facility will change in the same way as the fuel price. One of the greatest advantages of district heating is the availability of a range of different input fuels and it is common to use one type of fuel for base load production, and another for peak production. However, this may vary due to changing fuel prices. Low-cost fuels such as biomass and recycled heat are commonly used during summer, while more high-cost fuels are used during winter. This means that the marginal costs of district heating can vary seasonally during the year (Li et al., 2015).

The marginal cost of heat is closely related to the marginal cost of electricity. This is especially relevant for Norway, where the district heating price is linked to the electricity price by regulation, rather than to seasonal demand fluctuations. According to the Norwegian energy act §5-5, the charge for district heating cannot exceed the charge for electrical heating in the same supply area. This means that the electricity price will affect the marginal cost of district heating, and consequently the final price for consumers. The price for district heating must therefore be competitive with electricity prices (Naas-Bibow & Martinsen, 2011).